Squeezes in Non-Securities

A quick recap of the GameStop fiasco

At this point almost everyone has heard bits and pieces about GameStop. The entire story is incredibly complex, but here's the basic rundown:

GameStop sells video games in brick and mortar stores. It wasn't doing too well financially and its shares were unable to attract much interest. In fact, some hedge fund investors believed the firm's future to be so bleak that they decided to short the company's shares. This means that the investors inked a promise to sell some shares of the company, even though they didn't own them. The bet seemed like a no-brainer. If the stock price fell, the hedge fund would earn a ton of money. If, however, the stock price remained at its current level, the hedge fund would take a small loss. There was absolutely no reason to believe that GameStop's shares might rise. After all, it had minimal opportunities for innovation, expansion, or increasing goodwill.

Unfortunately, some participants on an internet discussion board realized that the hedge fund had agreed to sell more shares than actually existed. This meant that when it came time to settle up, the hedge fund would be forced to buy every share that it could get its hands on.

A once-in-a-lifetime opportunity had presented itself. Anyone could buy shares in GameStop knowing that the hedge fund would be forced to purchase GameStop's shares at any price. This is referred to as a short squeeze, because the people who had shorted the stock would be forced to buy shares, even if they knew that the share price was not based upon fundamentals.

The fundamentals of a short squeeze

The basic lesson of a short squeeze is that the prices of goods can deviate from their inherent value. Seemingly small shifts in market dynamics have the potential to increase vendors' pricing power and make them very wealthy in a very short period of time.

To simulate a short squeeze, you only need to accomplish two tasks:

1. Find (or create) a market in which buyers are desperate
2. Find (or create) a market in which buyers have few options

Increasing buyer desperation

The ideal customer is not one who merely wants to buy your product, he is one who has to buy your product. The more he needs to buy, the less price will factor into his decision-making process (assuming access to a sufficient source of funds).

Here are a couple of methods that can be used to push a customer from wanting to buy toward needing to buy.

Apply FOMO sales tactics

If you've ever spoken to a real estate agent, you've probably heard him say, They are not making any more land, so buy now or get priced out forever. If the going rate for an item is guaranteed to increase quickly, almost any price can be rationalized. Who wouldn't pay $1 million for a house that will be worth twice as much the following year?

Expose waiting costs

Whether they realize it or not, many customers are under immense pressure to make a purchase sooner rather than later.

Imagine that you're a car salesman. A potential customer comes into your showroom and says that his car just died, and he needs a new one to commute to work.

What would you do in response?

If your answer did not include the words raise my prices, you might want to rethink your career in automotive sales.

Think about the additional costs that such a shopper would have to pay. Each day that he delays his purchase would bring car rental fees, potential for lost income, and additional heartburn over the car buying process.

Even agreeing to pay a relatively high price might prove less expensive for the buyer than shopping around for a better deal.

Increase democratization of sales channels

The world loves to hear about efforts to remove middlemen from supply chains. Many armchair economists incorrectly assume, however, that such moves always benefit the end buyer. As vendors shift from attempting to please a handful of specialist middlemen, each controlling a large chunk of its income, to legions of unsophisticated and independent shoppers, vendors can and will find themselves with far more power to dictate pricing terms.

Push for quicker buying decisions

The less time that customers have to consider their options, the less informed and logical their decisions will become.

Last minute shifts in pricing may leave customers without sufficient time and energy to perform due diligence and shop around for a better offer. This is especially true with respect to renewal contracts.

Constraining buyers' options

Although a customer base primed to pay high prices can be valuable, it won't mean much if the customers can simply shop elsewhere. Vendors need to limit buyers' options.

Here are a few methods to do just that.

Convince competitors to work together

In most markets competition tends to drive down the price of goods. While low prices are often celebrated by consumers, they tend to erode a supplier's profitability.

As a result, vendors have an incentive to collude in order to keep their prices in the stratosphere. Although price fixing is illegal in the United States, OPEC and other international organizations spend considerable time and effort to establish pricing agreements. Other companies follow suit, though via more covert means.

It should be noted that there is a spectrum along which firms can operate when it comes to price collaboration. While explicit agreements are often met with lawsuits and criminal prosecution, many vendors have found other means of cooperation. Some rely on trade associations to achieve their goals, while others simply match competitors' price increases to discourage competition.

If you are thinking along these lines, make sure to speak to a lawyer, as the relevant laws are highly complex and vary by region and industry.

Demand increased regulation and oversight

Rulemaking bodies can and do reduce competition through various means such as:

• Capping the number of operating licenses
• Enforcing licensing qualifications
• Requiring insurance and bonding
• Specifying quality standards

While most businesses won't have sufficient political capital to push for beneficial regulation by federal or even state governments, they can often do so at the town or homeowners' association level. In some cases, either via the principal-agent problem, or sourcing incompetence, vendors can convince rulemaking bodies to submit to contracts that are either blatantly sole-sourced or are sole-sourced in everything but name due to carefully tailored requirements.

Assert control of the conversation

Advertising can shift what people think is proper and necessary. It wasn't that long ago that stocks were considered an investment only for the wealthy. Now they are perceived as the primary basis of retirement savings for the middle class.

Interestingly, the division between advertising and news is becoming increasingly blurry as many vendors have begun creating content.

Many business leaders freely take part in discussions with the media and the public. While it's possible that they do so out of selflessness, I would argue that the opportunity to pitch their offerings and promote the value of their brands may be more likely motivations.

Make use of anger and shame

Companies of all stripes are realizing that politics and business are getting intertwined. One can easily imagine that tying a firm to an unpopular political stance can effectively eliminate a vendor from many buyers' purchasing considerations.

Hoard supply

When one firm controls a large segment of a market, it can simply restrict the availability of its goods. The classic example of this behavior is, of course, De Beers. The famous diamond company mined plenty of diamonds but was careful to lock many of them in hidden vaults so as not to dilute the prices it could command.

Destroy secondary markets

Many businesses work to ensure that consumers see used goods as inferior, overpriced, risky, or socially unacceptable. In some cases the government can even take action to ensure that secondary markets are not allowed to operate at all (as was demonstrated by the cash for clunkers program a decade ago).

As long as customers do not see used goods as an option, those goods cannot be an option.

Ramp up differentiation

When a firm's offerings are perceived as fundamentally different from those of other suppliers, it essentially limits customer options. In many cases the differentiation need not relate to effectiveness or utility.

I recently needed to replace the screws for my car's license plate. When shopping, I didn't think to search for the screws by their size, I simply typed in the term license plate bolts.

There may have been plenty of alternatives that were cheaper than what I ultimately purchased, but I don't know. Few options showed up in my search results.

Many firms have taken note of this effect. The Coca-Cola brand doesn't advertise its flagship product as a cola; it advertises the famous drink as Coke.

Increase the cost of alternatives

Although few realize it, businesses enjoy an immense level of control over the costs of their competitor's offerings.

Through lock-in and increasing search costs, vendors can raise the ultimate price that customers must pay to buy a competitor's offering. With a bit of effort, this price increase may be enough to push the total cost of selecting a competitor out of buyers' consideration.

Increase the perceived risk of other alternatives

As I discussed in the recent article Why aren't you selling insurance?, the ability to signal an absence of risk is often enough to generate significant increases in perceived value.

Beware of the risks

It may seem like a walk in the park to push for something like a short squeeze, but it can be a very risky process.

Buyers tend to get very upset when they think vendors are taking advantage of them. Sometimes they respond with litigation. Other times they go out of their way to source inferior alternatives offerings.

A vendor may discover that it has misread the market entirely and find itself with a large unsold inventory unable to command the prices it expected.

Even when the market dynamics are perfectly understood, a third party can change the rules. The Hunt Brothers learned this painful lesson when the exchange that oversaw their business activities tweaked their requirements and destroyed the value of their investments overnight.

Because of the inherent dangers, vendors should always ask themselves whether gains from actions like short squeezes are worth the risk. The answer will depend heavily upon the nature of the business as well as the market in which it operates.

Conclusion

The news media seems to be solely focused upon stock price manipulation, but clever business owners can apply very similar strategies in non-financial markets. Much of it goes unnoticed by the world as vendors continue to strategize their way to substantial profits. Are you willing to follow suit?

Questions come from readers like you. If you'd like your questions answered, send them my way.